The Limits of the Market: The Pendulum between Government and Market, by (Oxford University Press, Oxford, 2017), 192 pp.
Paul De Grauwe's The Limits of the Market – originally written in Dutch (De Limieten van de Markt) and translated into English by Anna Asbury – is an excellent book on the ideological debate between market and state. The book is only 156 pages long (excluding prelims, notes and index) and is divided into 13 chapters. At an average length of about 12 pages, each chapter is a 12–15-minute read. The font size is large, a plus for those who love to read while commuting.
Chapters 1–8 form the foundation of the book, where De Grauwe outlines the internal and external limits of the market (capitalism) and government. The time span covered is the twentieth century. Chapter 1 discusses how the economic pendulum has swung between market and government systems in the past 100 years. After a protracted expansion of the capitalist system in the nineteenth century, the procession of the market system came to a halt during the first half of the twentieth century, thanks to two world wars and the Great Depression. As a result, government spending (as a percentage of GDP) rose in OECD countries, and taxes on the highest income also increased substantially, exceeding the 90 per cent threshold in the UK and USA. However, as the limits of the government-controlled economies became increasingly apparent (i.e. the twin problems of ‘limited information’ and ‘little incentive’), the 1980s saw the return of the market system. More countries reopened their borders and world trade was liberalised. Nowhere was this more evident than in the countries of East Asia, which grew at a spectacular speed. The force of capitalism seemed unstoppable, until the financial crisis of 2008.
In Chapters 2–4, the book systematically investigates various limits of capitalism. The central thesis of Chapter 2 is that the limits of a market system hinge upon the coordination between individual and collective rationality. This connection is then explored from two dimensions: the external and internal limits. The former is nothing but what economists call ‘externalities’, while the latter is analysed from the viewpoint of psychology. Here, the author uses System I (the emotional side) and System II (the rational side) of our brains to emphasise the point that for a market system to function properly, a delicate balance between the two systems is needed. Each of the two limits is discussed in detail in Chapter 3 (external limit) and Chapter 4 (internal limit). The conclusion of Chapter 3 is that an uncontrolled market system leads to degradation of the environment, increasing public harm and decreasing public good. In Chapter 4, De Grauwe shows his creativity by relating the demand–supply framework to the System I and II parts of our brains. He shares his personal experience with Eurostar rail to show how a market system can simultaneously generate both fair (System II) and unfair (System I) outcomes, causing a discrepancy between individual and collective well-being.
Chapter 5 questions whether the market contains self-regulating processes to prevent itself from self-destruction. The answer is ‘no’. He cites Simon Kuznets, who predicted that as a country gets richer, income inequality drops. That is, according to Kuznets, capitalism contains an in-built mechanism that would restrain income inequality from rising. De Grauwe argues that, except for a brief limited period between the two world wars, Kuznets's prediction turned out to be wrong. Indeed, recent evidence shows that inequality in the most developed capitalist countries has increased.
This is where the role of government becomes crucial and is the theme of Chapters 6–8. Chapter 6 teaches us what governments should do. The discussion emphasises three fundamental roles of the government: tackling externalities, supplying public goods, and redistribution. The picture that emerges is that, despite all good intentions, practical implementation of government regulations is imperfect. An example is the failure of the European Commission's emissions trading system due to the intense lobbying by the major energy-intensive industries that eventually led to the collapse of the price of carbon dioxide. Chapter 7 further elaborates on this tension between individual and collective interests under the label of ‘external limits of governments’. Unlike the market system, where individual decisions harm the collective good, in this case, government's effort to promote the collective interest can undermine private interests (e.g. company shareholders). But, in the absence of a functioning democracy, the political system supports the interests of the minority, while causing damage to the majority of people. This kind of ‘crony capitalism’ can be seen not only in countries in Asia, Africa, and Latin America, but also in the USA in recent decades. This outcome, in turn, makes many people dissatisfied with the market system, creating an opportunity for governments to address the unfairness using various non-market mechanisms.
One of the most widely used mechanisms that governments in rich countries rely on is spending on social security. Chapter 8 explores the pros and cons of such income redistribution policies through the lens of our emotions (System I). It makes the interesting observation that just as our emotions long for social benefits to deal with inequality and poverty, we also find it unfair when the unemployed person enjoys welfare benefits without trying to find a job. This paradoxical state of affairs of our brains with regard to social security captures the internal limits of government action. The lesson is plain: for social security to be effective and continuing, governments must keep moral hazard under control.
Chapter 9 concludes the debate between market and state by making the argument that both are like twin brothers, inseparable from their very existence. It dispels the myth, particularly for Scandinavian countries, of high labour costs as a barrier to competitiveness. Instead, it offers a new interpretation. High labour costs supported by high productivity have allowed northern European countries to enjoy superior education, healthcare, social facilities, and so on. Viewed this way, high salaries worked as a lever (instead of as a barrier) for increased competitiveness of the Scandinavian countries.
In Chapters 10–13, the author offers his thoughts on selected issues. Chapter 10 provides us a cyclical theory of capitalism, contrasting the linear theories of the rise and fall of capitalism proposed by Marx, Schumpeter, and Polanyi. The linear theories predicted that the end of capitalism would be followed permanently by some form of state control over the economy. In contrast, De Grauwe's cyclical theory of capitalism can be summarised as follows. The market system may often hit its limits (e.g. financial crisis) and may disappear, but only temporarily. And the state will not replace it because the state has its limitations/contradictions (e.g. governments defending capitalists’ interests). The market system re-emerges or is resurrected. That is what, according to De Grauwe, been going on for the last 200 years.
Chapter 11 discusses how the creation of the euro zone has undermined the power of national governments, at the cost of a more powerful market system (particularly financial markets). This point is made clear by simple use of data. After the financial crisis of 2008–2009, government debt (as a percentage of GDP) rose faster in the UK than in Spain; but the financial market punished Spain more severely than the UK by demanding a higher interest rate on Spanish 10-year government bonds. This puzzling discrepancy can be ascribed to the fact that unlike the UK, Spain, being in a monetary union, lost its freedom to print money to weaken any liquidity crisis. De Grauwe shows two options for solving the structural problems facing the governments in the euro zone: either create a political union so that the euro zone becomes a federal state or a return to national currencies.
In Chapter 12, De Grauwe analyses Piketty's now famous iron law: r > g. He cleverly relates the inequality r > g to the rentier class (those who own capital), just like the owners of capital in resource-rich economies. De Grauwe recommends a progressive wealth tax on rentier wealth to save capitalism from collapse. He also identifies two criticisms of Piketty. First, r > g may reflect a price effect in that the owners of capital (say, real estates) may be enjoying a temporary rise in prices. Second, the prediction that the return on capital will continue to rise may hit the limit in a world of abundance of capital. On the second criticism, Piketty's findings are that the return on capital is less than proportionate to the rise in the quantity of capital.
The book concludes (Chapter 13) with the question of how the pendulum between markets and governments will swing in the future. In addressing the question, the author offers both pessimistic and optimistic scenarios. The pessimistic view relates to governments’ inability to limit damage to the environment and reduce income inequality. The optimistic view, in turn, requires greater international coordination (e.g. taxation policies) and democratic institutions in combating pollution and income inequality. As so often, the reality will likely lie somewhere in between these pessimistic and optimistic views. De Grauwe is perhaps right to point to a more sombre future and that humanity may be left with the only option of doing as the Greek King Sisyphus did.
The book is just a joy to read. Both economists and general readers will find it very useful. Two omissions (or rather recent developments) come to mind. First, the rise of the digital economy (including complex algorithm-driven transactions) is helping markets to become even more powerful and less competitive, and governments seem unprepared to deal with this phenomenon. Second, the resurgence of state capitalists (including sovereign wealth funds) is rewriting the rules of the markets. To take one example, Ecuador and Guinea can bypass international credit markets and borrow from China at interest rates much lower than the market. More research is needed to understand the new dimensions of the market–state relationship.
